Former deputy Reserve Bank governor and currently research director at Brookings India Subir Gokarn said the proposed unwinding in quantitative easing may unleash adjustments in markets, following which attracting foreign funds may pose a challenge. Equity markets plunged on fears of portfolio outflows after Fed signalled US economy was ready for a stimulus pullback.

India is already facing tremendous pressure of a wide current account deficit and any desire to curb it is seriously obstructed by an ailing home currency. The Indian rupee plunged to its life low of 59.57 to a dollar at close on Thursday.

Speaking to CNBC-TV18, Gokarn said the government needs to take credible steps to tackle deficit, which will help rupee and sentiment in market. Meanwhile, Indian bond prices have fallen further and the 10-year bond's yield have risen by another three basis points to 7.42 percent on suspected FII selling; sentiment is also weak ahead of an auction today and because rate cut hopes have all but vanished. Gokarn, however, said that the RBI may still find elbow room to cut rates in its next policy.

Below is an edited transcript of the interview on CNBC-TV18

Q: Since we last spoke, it has been a steady downward spiral for the rupee. The question a lot of people are now beginning to slowly ask is: whether the macros and the currency set up resembles some kind of currency crisis for us?

A: When we look at what happened last week, it was precipitated essentially by the same set of factors that did yesterday’s damage. That was the hint or the signal from the Fed that the quantitative easing (QE) would be rolled back. Then two days ago that signal was confirmed; it was made explicit.

So you really have to look at this as part of the overall adjustment, both before and after the announcement, to the new liquidity scenario that will emerge once the QE is actually rolled back. So, as people have been saying, there is certainly an overshoot element in this particular adjustment where all global portfolios will first take stock of what the new liquidity scenario will mean for them and then there will be some reallocation, which will lead to some sort of normalization.

Now, the question is: what do you do from a policy perspective to ensure that when that normalization takes place some of those funds are going to come back into your markets? That is the challenge that the policy establishment faces and to a large extent other emerging economies as well.

Q: Last couple of years this problem was there. The current account deficit (CAD) was always large but we just had the comfort of the global liquidity actually putting some kind of a plug on that. Do you think we can do something on the policy front quickly over the next few weeks, which can tell global investors they don't need to take money out of India in their reallocation or do you think this global phenomena will hurt us anyway?

A: That is the key. When it comes to taking specific steps to stem the flow, people will start getting a little tempted to impose some kind of control or the other. Some control on outflows, some control on trade. We need to resist that because these can have very negative long-term negative consequences particularly if this process of adjustment is essentially a short lived one.

However, when the money starts to get reallocated, as I believe it will, what we have done in terms of credible concrete actions to narrow the gap are going to be very critical. We talked last time about the gold issue, the oil issue, about the minerals issue—all of these are pressure points on the current account which can be reversed. At least credible steps can be taken to signal that these pressures will be eased overtime, not overnight. That is very important.

There is some news about a meeting on July 1 to take stock and to put out a time bound action plan. That will be a very critical point at which the signal of commitment and credibility should go out. And if that is established, if concrete time frames are set, if reasonable actions are proposed, when the reallocations happens I think that does provide something of a platform for normalisation take place.

However, if that doesn’t happen clearly than the pressure of the CAD will be seen as a much more persistent and permanent pressure and that can have consequences for the currency beyond the immediate future.

Q: The other thing which people have started debating is: what flexibility the Reserve Bank of India (RBI) has going forward to reduce rates in a scenario where imported inflation, because of the rupee, will go up and the US bond yield has started hardening quite significantly? Do you think the elbowroom is vastly diminished now compared to what it was even a month back?

A: The elbowroom is partly a function of the exchange rate. It is also partly a function of what happens to commodity prices. Now, clearly with the liquidity reversal or the rollback, along with other asset classes, we should expect to see some correction in commodities. There is a general perception that the reason why oil prices are so high even at this point in the business cycle is liquidity, is that it is asset class.

So if there is a rollback then that may to some extent offset the currency dynamics. If the currency readjusts ones global portfolio allocations normalize then there may be some room but both of these factors are going to play a role and they are both moving in somewhat different direction right now. So there is an offset factor there. Overall, if commodity prices remain where they are for whatever reason and the currency continues to slip, then the inflationary consequences of the depreciation have to be taken into account.